Bond yields have risen – not just in the United States but overseas as well.
Over the past five months or so since the election, the yield on 10-year treasury bonds has more than doubled, rising from 0.7 percent to 1.7 percent. In Britain, the yield on 10-year government bonds, called gilts, has jumped from 0.3 percent to 0.8 percent. German government bonds continue to offer negative yields, but they have moved up much closer to zero than they were. The Federal Reserve (Fed) and Washington in general have expressed concerns: that the rise will stall the economy’s recovery and that bond market behavior of this sort will limit policy flexibility. The first of these concerns is misplaced. Rather than interfere with the recovery, the rise in yields in part reflects confidence that a strong recovery is in prospect. The second concern is more on the mark. In large part, the market’s move reflects the judgement that both monetary and fiscal policy are not what they should be, at least from a bond-holder’s perspective.
On this second point, matters have begun – though only just begun – to resemble the patterns of the early 1990s. Back then, bond investors, having suffered horribly from high rates of inflation during the 1970s and frighteningly high federal budget deficits in the 1980s, reacted quickly and violently to any policy move that even hinted at a return of such troubles. A rise in government spending or an easier monetary stance would cause a sudden bond retreat and consequently an equally sudden rise in yields. Because bond investors seemed to respond violently to anything amiss and often force a change in government policy, journalists and commentators came to refer to market participants as “bond vigilantes.” This “vigilante” power so impressed James Carville, aid to then presidential hopeful Bill Clinton, he announced that in his next life he wanted to come back as the bond market. No one in Washington today – Democrat or Republican – wants to feel the weight of that market judgement again.
Unlike the 1990s, it is not just a policy judgement that has prompted the bond move. The yield rise reflects policy concerns, to be sure, but bonds are reeling now from what might be described as a four-punch combination.
The first of these punches came out of the untenable state of bond markets toward the end of 2020. With short-term interest rates driven down to about zero and actually negative in some places and active bond buying on financial markets by the Federal Reserve (Fed) and other central banks, bond yields had already fallen below the rate of inflation. Without some major policy push to drive rates and yields down farther (and so prices up higher) bond holding was already a losing proposition in real terms. Meanwhile, the Fed and other central banks showed little likelihood of adding still more support to markets than they were already providing. In other words, bonds were an unattractive investment. Their yields lost to even modest inflation and bond prices were more likely to see declines than increases. To be sure, less credit worthy bonds continued to offer yields above the rate of inflation, but the risk involved in buying them recommended other investments over bond buying. In such an environment, anything in the least bit discouraging could tip the flow of monies away from bonds.
Throwing a second punch is the widespread recognition that the Fed’s ongoing liquidity support could always cut two ways. It might sustain demand for financial assets, including bonds, but longer-term and more fundamentally, a surplus of liquidity also always threatened accelerating inflation that would erode the real value of the interest earned on bonds. While the pandemic raged, investors thought little about inflation, especially since the economy had enjoyed a long stretch of low inflation before the virus arrived, but with vaccinations spreading and a full or almost-full economic re-opening in prospect, these once secondary inflation concerns have begun to gain prominence.
To be sure, Fed Chairman Jay Powell has assured all and sundry that inflation is not a concern. Still, bond investors looked at consensus expectations for 4.7 percent real economic growth in 2021 and 3.6 percent in 2022, and because both exceed the long-term average, they cannot share his optimism. They can see that such growth will exceed historic trends in the U.S. economy by a wide margin, implying that the economy would return rapidly to full employment and accordingly develop a potential for economic overheating and inflation. The Fed’s clear intention to continue pouring liquidity on the economy in the interim only adds to such concerns. In this respect, the rise in yields does carry something of a “vigilante”-like judgement.
Concrete evidence of inflationary pressure has thrown a third punch. Even at the consumer level, there are hints. After years during which retail prices rose by no more than 2 percent a year, the opening months of 2021 have seen consumer prices rise at a 4.5 percent annual rate. More sensitive price measures also point to at least some inflationary pressure. Commodity prices have risen sharply since the middle of 2020. Copper prices, for example. have jumped some 25 percent during this time. Other industrial commodities have shown a gain of 30 percent. Oil prices are up 50 percent. Meanwhile, the Labor Department reports that producer prices, what producers pay for their inputs, after years of showing zero inflation, have risen at over a 5 percent annual rate since the middle of last year.
The fourth punch, the one most recent, does emanate from a “vigilante”-like judgement on the deteriorating picture of federal finances. Concerns on this front have grown especially since the election. There can be little doubt that federal finances had taken a bad turn long before November’s vote. Tax cuts in 2017 had already enlarged budget deficits greatly and spending to bolster the economy during the pandemic had added to the flow of red ink, which official sources projected to reach $2.3 trillion in 2021, some 10.3 percent of the nation’s gross domestic product (GDP), well above historic norms of about 3 percent. With President Biden’s addition $1.9 trillion in spending, 2021 deficits look likely to exceed $4 trillion, almost 18 percent of GDP.
Especially since the economy is expected to surge with the planned re-opening, many economists, even Democratic economists like Larry Somers, have warned that this additional spending is excessive and could lead to economic overheating. An inflation threat is implied. Considering that the new White House is now talking about trillions in spending for infrastructure and elements of the Green New Deal, the prospect of over stimulus and an overheated and inflationary economy have become real. If this were not enough to frighten bond investors, the flood tide of red ink implies that tremendous federal borrowing will create a huge supply of new debt and an inevitable downward pressure on bond prices.
No doubt the news on inflation will vary in coming weeks and months, and bond markets will fluctuate accordingly.
News on the extent of economic recovery will also vary and bonds will reflect that, too. But the longer Washington shows little inclination to address the policy picture, the more intense the bond market’s “vigilante” nature will emerge. Since no one group has the answers to all the country’s economic needs, perhaps the bond market’s judgement can serve a useful purpose by forcing both the Fed and the administration to reconsider from time to time and at the very least justify decisions to the satisfaction of those who have to live with them.